Rate Hikes or No Rate Hikes?

Raghuram Rajan of the University of Chicago, along with William White, former head of the Bank for International Settlements’ monetary and economic department, are arguing for an increase in interest rates.

Interest rates near zero risk fanning asset bubbles or propping up inefficient companies, say Rajan and William White, former head of the Bank for International Settlements’ monetary and economic department. After Europe’s debt crisis recedes, Fed Chairman Ben S. Bernanke should start increasing his benchmark rate by as much as 2 percentage points so it’s no longer negative in real terms, Rajan says. [link]

There is an element of truth to this, with firms now issuing 100-year bonds. This has turned into a bit of a controversy, with Paul Krugman commenting on the statement in a post on his blog:

other things equal, demand is higher, the lower the real interest rate. Do you really want to quarrel with that? But right now, thanks to the aftermath of the financial crisis, even a zero nominal rate, which is a slightly negative real rate, isn’t low enough to produce full employment.

In normal times, when the zero lower bound isn’t binding, this basic framework suggests that conventional monetary policy can play the key role in stabilization. So in normal times I’m all in favor of having the Fed take on the job of managing the business cycle, and basing fiscal policy on long-term concerns. [link]

The Keynesian argument is to have the government take over from the private sector and push-start the economy until it gets rolling again. To be sure, there are problems with this, including what Rajan talks about: short-term thinking, free riders, etc. But in the long-run Krugman might be right. In any event, Rajan responded on the Freakonomics blog with:

The asymmetric Fed policy of cutting rates sharply when the economy is in trouble and not raising them quickly when it recovers gives the financial sector fewer incentives to worry about credit or liquidity risk. The financial sector has come to rely on the Fed to bail it out through ultra-low interest rates whenever it gets into trouble, and the Fed has developed a reputation of obliging.

cutting rates is not without cost. But what about the benefits? Are they as large as the Keynesians state them to be?

The real problem is that corporations are not hiring quickly. But corporations did not hire quickly following the recession of 2001 (or that of 1990-91), and the sustained monetary stimulus that many economists supported then led, in no small part, to the housing boom and bust. It did not, however, lead to an explosion in corporate investment. [link]

So who is right? It is hard to say right now – only time will tell. But with double-dips looming, and bankers’ bonuses booming, the FOMC has its work cut out for them.

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